CWS Market Review – August 23, 2013

“To achieve satisfactory investment results is easier than most people realize;
to achieve superior results is harder than it looks.” – Benjamin Graham

Wall Street’s been having a tough time so far this August. Through Wednesday, the S&P 500 fell on ten of the previous 13 days. Thanks to the low volatility of late summer, these dips haven’t stung very much. Measuring from the market’s peak on August 2, the index lost nearly 4%, though we gained some of that back on Thursday. Interestingly, the Dow Industrials fell to their lowest level relative to the S&P 500 in five years.

Now a 4% haircut isn’t much of a downswing. It’s only a minor dent in the rally we’ve had this year. However, the big concern on everyone’s mind is that Ben Bernanke and his friends at the Fed are finally going to start “tapering” their bond purchases next month. I’ll have more on that in a bit. Wall Street had more headaches yesterday as “technical issues” caused trading to be halted on the Nasdaq for three hours.

But the action that’s caught my attention hasn’t been in the stock market. It’s in the bond market. Interest rates have spiked dramatically in the U.S., and the long bond is near its worst selloff in 13 years. In early May, the 10-year Treasury was yielding 1.63% (see chart below). On Thursday, the yield got as high as 2.92%, and a lot of folks expect us to break 3% any day now.

In this week’s CWS Market Review, we’ll take a closer look at what’s causing bond traders so much grief. We’ll also take a look at recent Buy List earnings reports from Medtronic ($MDT) and Ross Stores ($ROST). (Ross beat consensus by five cents per share and looks to break out soon.) But first, let’s focus on the dramatic rise in bond yields.

Why Are Rates Rising? It’s the Economy

The stock and bond markets have a rather unusual relationship. The two markets can basically be described as “frenemies.” On one level, they’re competitors for investors’ capital. Money will go wherever it’s treated best. The catch is that neither market will prosper for long if the other one is suffering. After all, the bond market is debt, and if companies have to shell out higher interest costs, that will cut into their bottom line. Meanwhile, if companies aren’t making a profit, then they can’t pay back their loans. Stocks and bonds are rivals under the same flag.

Sometimes the two markets move together as if they’re waltzing partners, and other times they act in near-perfect opposition. As a very general rule of thumb, the bond market leads the stock market by about six months to a year.

Long-term interest rates officially hit their low thirteen months ago, but the decline since then was rather slight. That is, until this May, when the rout really got going. The 10-year yield is now where the 20-year yield was in June, and where the 30-year yield was in May. So the question to ask is, why is the bond market falling so sharply?

The popular answer is that it’s due to the Federal Reserve pulling out of its bond buying. But I’m not so sure. Let’s review the situation: The Fed meets again in mid-September, and the central bank has successfully convinced Wall Street to expect a scaling-back of asset purchases. This week, in fact, the Fed released the minutes of its last meeting, and those minutes indicated that the other FOMC members are on board with Bernanke’s tapering plan. Personally, I think it’s too early to start tapering. If they do announce a tapering, and they probably will, I expect it to be modest, which means the Fed hasn’t left the bond market at all: they’re simply buying less. This really shouldn’t be a big deal.

That’s why I don’t believe the taper talk is the reason for higher interest rates. Other people think the higher rates are due to inflation. The gold market has rebounded lately, but that’s coming after a pretty rough year. The yellow metal is still off more than $500 an ounce since last year’s high. The CPI reports continue to be quite tame. Also, the yield on the 10-year TIPs, the inflation-protected bonds, has climbed largely in step with the regular 10-year bond (see chart below). In other words, investors aren’t demanding a greater inflation discount for their bonds. They just want a higher yield.

The influence of the Fed does show up in the middle part of the yield curve. For example, the spread between the two- and three-year Treasuries was only 10 basis points on May 6. Now it’s up to 40 points. That’s probably investors factoring in a short-term rate increase down the road. Interestingly, spreads among longer-dated bonds have actually tightened up a bit.

This leads me to believe that the reason for the higher rates is an improving economy. The key fact in favor of this thesis is that the dollar has been fairly stable. If yields were rising as the dollar was falling, then I’d be more concerned. I’ve also been impressed by how economically cyclical stocks have held up, and that’s despite a weak market for tech stocks. We also got encouraging earnings reports this week from broad-based retailers like Best Buy ($BBY) and TJX ($TJX). Also, Home Depot ($HD) had a good report plus they raised guidance.

The most intriguing bit of evidence in favor of the stronger-economy view is that junk-bond spreads have narrowed. In an unusual twist, AA-rated bonds are now yielding less than AAA bonds. But that’s not due to the market’s irrationality (which we can never completely discount). Rather, it’s due to the fact that investors want the shorter maturities that AA bonds usually carry. So investors want still bonds; they’re simply less willing to get locked into long positions.

Mortgage rates have climbed as well, and I am concerned that that could disrupt the housing market. The recent reports, however, show that housing is doing quite well. Our Buy List member Wells Fargo ($WFC) made news this week when they announced they’re eliminating 2,300 mortgage jobs. But that’s due to a decline in refinancings, not fewer originations.

The takeaway for investors is to not be too concerned about any taper talk. Its influence on the market is easily overstated. If bond traders are right, the economy is due for a rebound later this year and into 2014. That will be very good for our Buy List. Now let’s turn to our recent earnings reports.

Medtronic Hits Earnings Consensus on the Nose

On Tuesday, Medtronic ($MDT) reported fiscal first-quarter earnings of 88 cents per share, which was in line with expectations. Revenues rose to $4.08 billion, which was $40 million short of estimates.

Shares of Medtronic pulled back after the earnings report, but I think it was a fine quarter. Demand for defibrillators was a bit weak, as was the demand for MDT’s InFuse bone-growth product. Interestingly, Medtronic said they’re planning to expand beyond medical devices and into health services. I think that’s a smart move.

Medtronic’s CEO, Omar Ishrak, said, “We delivered on the bottom line, overcoming a number of challenges through strong operating discipline.” The best news was that MDT reiterated its full-year forecast of $3.80 to $3.85 per share. That’s for fiscal 2014, which ends next April. They made $3.75 per share last year and $3.46 per share the year before. In June, Medtronic raised its dividend for the 36th year in a row. Business is still going well here, and I think they can easily hit their full-year guidance. Ishrak said they’re looking to generate $25 billion in free cash flow over the next five years. Medtronic remains a solid buy up to $57 per share.

Ross Stores Delivers a Solid Earnings Report

After the close on Thursday, Ross Stores ($ROST) showed very strong fiscal Q2 earnings of 98 cents per share. That was five cents better than Wall Street’s consensus. It was even better than Ross’s own projections. After the last earnings report in May, Ross said to expect Q2 earnings to range between 89 and 93 cents per share.

Quarterly sales rose 9% to $2.551 billion. The important metric for retailers, comparable-store sales, rose 4% last quarter. That’s a very good number. ROST’s CEO, Michael Balmuth, said, “Operating margin for the second quarter grew to a record 13.6%, up from 12.8% in the prior year.” For Q2, Balmuth said he sees earnings coming in between 75 cents and 78 cents per share. That’s below Wall Street’s consensus of 79 cents per share, but Balmuth noted that it’s a cautious outlook.

For Q4, Ross sees earnings ranging between 99 cents and $1.03 per share. Wall Street had been expecting $1.10 per share. The guidance for Q3 and Q4 is based on comparable-store sales growth of 2% to 3%, which is very conservative. Add it all up, and Ross sees full-year earnings of $3.80 to $3.87 per share. Note that last year’s fiscal year included 53 weeks. Adjusting for that, Ross is projecting earnings growth of 11% to 13%.

This was an excellent quarter for Ross. Don’t let the tepid forecast bother you. They’re just being conservative. Ross Stores is an excellent buy up to $70 per share.

Before I go, I want to highlight three especially good buys on our Buy List. Ford ($F) looks very good below $17. The stock actually dipped below $16 earlier this week. The last earnings report was outstanding. Cognizant Technology ($CTSH) is a very good buy if you can get it below $73 per share. The recent earnings report and guidance was also very good. Keeping with tech, Microsoft ($MSFT) is a bargain below $33 per share. The stock currently yields 2.84%, and you can expect a dividend increase next month.

That’s all for now. Next week is the final week of summer. It went by fast, didn’t it? I expect trading activity to remain subdued until after Labor Day. On Monday, the census Bureau will report on durable orders. The report will come on Wednesday, when the government will revise the Q2 GDP growth numbers. The initial report was a sluggish 1.7%, but the subsequent trade numbers suggest a strong upward revision. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Posted by Eddy Elfenbein on August 23rd, 2013 at 7:13 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Tickers: f, mdt, msft, ROST